The consumer price index (CPI) is a measure of the overall price level of goods and services bought by a typical consumer in a particular economy. Its goal is to measure the cost of living and show the effects of inflation on individual consumers. However, like most indicators, the CPI has its shortcomings. Specifically, there are four limitations of the consumer price index that you should be aware of: (1) the substitution bias, (2) the representation of novelty, (3) the effects of quality changes, and (4) the possible lack of individual relevance. In the following paragraphs, we will look at each of them in more detail.
1) Substitution Bias
The substitution bias causes certain increases in price to be overstated because it ignores the presence of substitutes. More specifically, the reason for this is that not all prices change proportionately. While some prices may rise from one year to the next, others may fall, and some of them won’t move at all. Now, consumers respond to these changes by buying more of the goods that become relatively cheaper and less of those that become relatively more expensive. That is, they substitute some of the more expensive goods for cheaper alternatives. However, because the CPI is calculated with a fixed basket of goods, it cannot include this effect (i.e., it just assumes that people continue to buy the more expensive goods instead of switching to cheaper ones). Hence, an increase in the price of a good in the index may be overstated.
For example, let’s say burgers are included in the CPI while hot dogs aren’t. When the price of burgers increases, people will eat more hot dogs instead (because they become relatively cheaper). However, because the index is based on a fixed basket of goods, it does not take this into account. Instead, it simply assumes that people will continue to eat burgers and pay the higher price. As a result, the increase in the cost of living reported by the index is higher than the actual increase, because it ignores the fact that consumers may switch to cheaper hot dogs instead.
2) Representation of Novelty
The representation of novelty in the CPI results in a temporary distortion of the actual cost of living after the introduction of new products. The reason for this is that people have a wider variety of goods or services to choose from, whenever new products are introduced. However, for products to be included in the CPI, they need to be bought consistently and in significant quantities (usually for several years). Therefore it may take multiple years before new products or innovations are included in the basket and thereby represented in the CPI. Other indicators, such as the GDP deflator represent these changes more quickly and accurately.
To give an example, let’s assume Tesla releases an affordable flying car next year. Flying cars are obviously much faster than regular cars, so many consumers abandon road traffic within a few weeks. However, the new flying cars will not be included in the CPI at this point. It will take several months or years of consistent consumer purchases before they will become part of the fixed basket.
3) Effects of Quality Changes
The effects of quality changes cannot always be accurately represented because the quality is extremely hard to measure. If the quality of a good deteriorates from one year to the next, the value of this good decreases even if its price remains the same. This essentially has the same effect as an increase in price (i.e., consumers receive less value per dollar). The CPI does not take these changes into account by default. However, the US Bureau of Labor Statistics (BLS) updates the basket regularly to reflect changes in quality. However, despite sophisticated measures and scientific methods (e.g., hedonic quality adjustment), it is extremely difficult to measure and include quality changes in the basket accurately.
For example, the quality of computers constantly increases due to technological progress. Therefore, the consumer price index has to be adjusted on a regular basis to reflect these changes. However, there is no bulletproof method to measure the increase in quality (or its value), which makes it difficult to include the value increase in the consumer price index accurately.
4) Lack of Individual Relevance
The consumer price index may not accurately report the level of inflation experienced by an individual because it measures the price level and inflation based on a typical consumer. Simply put, if the spending patterns of an individual are different from those of an average consumer, the numbers reported by the CPI may not be particularly relevant for that individual.
For example, let’s say you own a house and a car. You will probably have to spend a significant amount of your income on mortgage and fuel. So if the prices of mortgages and gas increase, you will personally experience a disproportionate increase in the level of inflation (as compared to the CPI). Meanwhile, someone who neither owns a car nor a house will experience no inflation at all.
In a Nutshell
The goal of the consumer price index (CPI) is to measure the cost of living and show the effects of inflation on individual consumers. However, CPI has four important limitations. (1) The substitution bias causes certain increases in price to be overstated because it ignores the presence of substitutes (2) The representation of novelty results in a temporary distortion of the actual cost of living after the introduction of new products. (3) The effects of quality changes cannot always be represented accurately because the quality is extremely hard to measure. (4) And finally, the CPI may not accurately report the level of inflation experienced by an individual, because it measures the price level and inflation based on a typical consumer.